Holdout creditors score win in long awaited US Appeals Court "pari passu" rulingArgentina likely to exhaust alternatives before considering compromiseArgentina's performing bond market can suffer further from "friendly", as well as "enemy fire"Cut Argentina debt to marketweight in model portfolio

Hold out creditors litigating against Argentina in US courts have brought forward Halloween holiday this year. The "trick or treat" was issued via a US Appeals Court ruling which resonated negatively in bond markets. The problem for the market is that Argentina is being told to "treat" but performing debt bondholders are the potential victims of a (very nasty) "trick" if Argentina does not concede hand outs.

In this note we complete the thoughts that formed our immediate impressions in response the news of the adverse ruling for Argentina ("Argentina: Court rules pari passu—quick & dirty and negative"). In a nutshell, as we think about the details and possible scenarios our concerns over the risk this litigation poses to Argentine performing bond holders remains large.

This ruling is the key headline risk event that the market has been waiting for but the result is not what the market was expecting. Thus, it is negative for the soverign debt. Whether the risks are worth more than the $7.0-9.5 price gap in long-duration performing bonds that already transpired is the key question investors face.

We believe the market worries are unlikely to resolved for better or for worse in the near term and hence market anxiety may escalate. Given the legal complexities of the case and the fact that a politically-charged decision now lies unpredicatbly in Argentina's lap, we prefer to stay sidelined at this stage and recommend cutting Argentina exposure to marketweight (see last section below).

The ruling is very harsh, raising risks of an adverse "end game" for performing debt

With regards to the ruling there are many things to highlight. We abstract from an analyzing arguments driving the decision in depth (sufficient is to say that the Appeals Court literally trashed a laundry list of Argentina's arguments—with one caveat). The main take aways are the following:

1. The ruling AFFIRMS the judgements of the district court against based on breach of "pari passu" (i.e. issuing an opinion on the "broad" definition that serves establish precedents for sovereigns in general, not just the "narrow" definition based on argument of the "lock law" specific to Argentina).

For practical purposes, this boils down to disallowing Argentina to pay holders of restructured bonds in US territory unless it pays holdout creditors in the lawsuit (with claims worth $1.33 bn)—despite the payments are in a bondholder trust which technically means they are no longer property of Argentina. Specifically, this involves 2005 and 2010 Exchange Securities which we interpret to mean Discount, Pars, GDP Coupons and Global 17s under foreign law, which includes USD-denominated NY law and EUR denominated UK law securities; in contrast, bonds from those same exchanges but under Argentine law, irrespective of whether they are USD or ARS, are not affected as they are paid outside US jurisdiction).

2. The case is REMANDED to District Court so that two issues are clarified :(i.e. the "pro rata" formula and the injunction's application to third parties and intermediary banks) and then will be returned to Appeals court for FURTHER CONSIDERATION.

While this may generate a perception that the Appeals Court can change its mind if the District Court clarifications do not satisfy it, we doubt this is likely to happen. The pro-rata formula (while critical for all parties and potentially controversial) once defined is a technicality and it is unlikely to be scrutinized by the Appeals Court. We suspect that the clarification regarding financial intermediaries can be resolved if a definition is narrowed in a way that institutions are unaffected when they (a) are in the chain of payment for Exchange Securities that do not directly recieve proceeds from Argentina or in trust for bondholders (but caught somewhere between) or (b) involved in transactions unrelated to Exchange Securities being targeted (for example, a payment of a different bond)

3. The ruling does not mention the stays on the injunctions that the District Court concended to Argentina for the purpose of allowing it to proceed with its appeal.

The lack of reference to the 'stays' raises a valid concern that if a solution is not adopted quickly by parties involved, the District Court injunctions and the Appeals Court affirmation would already apply to upcoming coupons on Exchange Securities due in December of 2012 (Discounts and GDP warrants). The worry is that without stays a potentially defensive and hasty political response from Argentina might surface, irrespective of the collateral damage to the bond markets it may entail. However, we believe that—with the remend requested and with Argentina sure to seek a "certioari" of the US Supreme Court—it is more likely that the threatening remedies will not be enforced until the judiciary process is complete (which, given court timing, inclines us to think that December 2012 coupons will be paid as usual). In fact, Argentina's Secretary of Finance Cosentino addressed this issue in a public statement, ratifying that the "stays" are in place currently.

Next steps: The ball is Argentina's (better said, Cristina's) court

The end game in this litigation will depend on Argentina's response. Below are some thoughts on the path ahead and a lot of concerns over the political capacity of the government to find a solution that limits collateral damage to the bond market:

1. Argentina can choose abide by the Courts and settle with hold out creditors the claims. Litigation claims ($1.33 billion) can be settled without affecting Argentina's broader payment capacity (and hence the risk premium on Argentina performing bonds). Argentina can dip into its $45 billion of reserves to make the payment as it currently does for performing debt service.

However, there are economic and a political factors at play that make this unlikely: On the economic side, we note that there are a total of $6.6 billion untendered debt (litigating and non-litigating), mostly foreign law, that could "piggy back" on this ruling to demand similar compensation. And considering that Argentina's definition of claims is limited to principal (but plaintiffs could demand PDI since 2001) the liability can conceivably inflate to an figure in the neighborhood of $11-12 billion. So it is not clear that a "small" $1.3 billion payment (or some lower amount settled privately between plaintiffs and Argentina) closes the door on the issue.

Political considerations are more worrisome. In our view the alternative of settling claims with litigating investors looks like a difficult pill to swallow politically for a government that has publicly blasted the "vulture funds" as public enemy No. 1 (but not exclusively so) of the Argentine people. We give a slim chance to this unless plaintiffs accept a similar deal similar to the restructuring exchange (which allows the government an elegant exit: selling the deal publicly as one that respects the terms of its own original proposal). Yet, should plaintiffs be expected to accept such a proposal after years of litigation? We are doubtful... but we (and bond markets) would be relieved to be proven wrong.

What could trigger an surprise compromise by Argentina? Maybe, the silver lining in the YPF nationalization is that now the government has a need for the state-run oil company to raise funds that help it fulfill the investment goals the President cares about. And maybe, the government acknowledges that it must resolve litigation uncertainty in a cooperative manner to make yields attractive for YPF and make its strategy to solve the energy imbalance feasible again. But too many "maybes"—and a leap of faith that the government will readily adopt economic cost-benefit analysis over political calculation—are involved in this vision for comfort.

2. Argentina is sure to appeal (or seek "certiaori"): Argentina's public statements (from Secretary of Finance Cosentino) in response to emphasized that the latter "is not the end of litigation" making it clear that the next step is to seek a judiciary review of the ruling. What is not clear is if Argentina will appeal immediately or wait for Judge Griesa to resolve on the clarifications required by the Appeals Court.

We understand that an Appeal can be made by Argentina to an expanded Appeals Court before the sovereign would need to seek a "certiaori" from the US Supreme Court. This again suggests that performing bond coupons are not immediately threatened. The clock on the threat to coupon payments on restructured debt starts ticking once the Supreme Court rejects the case or if it accepts it and subsequently affirms the injunctions. The Supreme Court might take 3-6 months to decide to take Argentina's appeal or reject it. So an appeal buys time and reduces the risk of a defensive and hasty response by Argentina that inflicts collateral damage.

A Supreme Court ruling could eventually overturn the Appeals Court. At the end of day, Argentina has already proven capable of doing so in other litigation also involving holdout creditors. Moreover, recall the US government did submit an Amicus Brief siding with Argentina on the (broad) interpretation of "pari passu" that might be taken into account (although the Appeals Court evidently brushed its relevance aside). Assessing those chances, however, is the subject of a different conversation that involves analyzing in detail the arguments supporting the ruling.

3. Argentina can try to re-route the payments on restructured debt: To avoid making payments in US jurisdiction Argentina might consider offering performing debt holders payment of coupons into a new offshore trust.

Legally, this is complicated to the extent that one of the orders of the judge requires Argentina not to modify its payment mechanisms for Exchange Securities. Evidently Argentina, in exercise of sovereignty, may attempt to do so anyway. Yet financial institions under NY law that facilitate such a scheme might be liable to being labeled in contempt of court and therefore Argentina would rely on other institutions to help it carry out such a plan.

But in addition, a successful execution would require solving some operational unknowns. We have heard opinions from legal experts that payment to the Trust in NY is "hard-wired" into bond contracts. If so, to re-route payments offshore (outside US) Argentina may need to carry out an exchange with current restructured debt holders. Yet an offshore payment would sacrifice US legislation and—while it is clear investors have an incentive to facilitate the payment of their coupons—it is not clear if they would rush to embrace a different legislation. Argentina can argue that a full payment in USD in Argentina should be viewed as superior to risk of payments being pro-rata in NY. But following all the noise around risk of "pesofication" we doubt all investors dependant on the BoNY trust structure have the appetite to make the gamble. A foreign non-US jurisdiction (UK?) might offer a (temporary?) shelter to continue payments but 100% participation in a swap of this kind has slim chances.

4. Argentina can unilaterally decide to set aside future coupon payments in an (offshore) trust as a display of willingness and capacity to pay, risking accusations of default. If Argentina does not want to play the cards it has been dealt within the established rules it may consider rewriting these rules in a convenient way. It might be deemed a political "face saver" to announce that it will deposit funds for Exchange Securities in a separate offshore trust that respects restructured bond holders claims but defies litigating creditors claims and US court orders to pay them pro-rata.

This option would lead to further collateral damage in bond markets. If the coupons do not reach their original destiny and the latter is truely "hard-wired" into bond contracts (as has been suggested to us) this option would likely qualify as a default. Of course, technically a formal default triggering CDS would have to be defined by market participants responsible for that process. Argentina's situation, if it chooses to stay current on restructured bonds but paying into a different trust, would at a minimum raise controversial opinions in this process. Moreover, for a CDS trade to look attractive bonds must trade at distressed prices that make them cheap to deliver and it is not clear they will if Argentina actually continues to pay the corresponding cashflows on the bonds.

Final thoughts: Any safe havens?

Unfortunately, Argentina's poor communication with markets does not provide assurance that the sovereign will (or even can) signal its strategy clearly and in a pre-emptive fashion that might help to reduce market anxiety rapidly. Thus, "pari passu" litigation will remain an overhang for the bond market.

All bonds—irrespective of currency—that are under local law and paid through mechanisms not within the jurisdiction of the NY court are spared from the "pari passu" litigation consequences. In the near term, the local law USD bonds like Bodens and Bonars have suffered though less than foreign law bonds due to shorter duration and due to investor understanding that they can continue to be paid by Argentina without third party interference.

We moved overweight Argentina in our EMBIG Model Portfolio on 17th September as a supportive environment post the Fed’s announcement of QE3 provided support for high spread Emerging Maket sovereign performance and we saw a cyclical lift to the domestic economy in 2013, with ‘no news’ for a period in Argentina being good news for bond prices. Today’s 'news' from the pari passu court ruling is a negative risk we highlighted at the time and we see a period of uncertainty ahead. We entered the overweight when Argentina (global) 8.75% $ 2017s were at a price of 100.00, which was a spread to treasuries of 801bp versus the EMBIG spread then at 282bp. We take losses on this overweight and move back to marketweight given the downside risks, with current prices of Argentina (global) 8.75% $ 2017s down at 91.00/95.00 (spread to USTs of 1,053bp / 935bp as at 1.30pm US time 26th Oct).

We rebalance other positions in our EMBIG Model Portfolio to keep the overall portfolio position unchanged. Many questions remain about the next steps in this process, which is unusual in that there is potential risk to bond holder payments that is not being driven by the unwillingness or inability of the issuing government (Argentina) directly. The reaction of the government to this ruling and the next legal stages are not yet known and may turn out to delay or avoid any impacts on bond payments. This keeps from wanting to move underweight at this stage, until we have more clarity on these next steps and given the price drop already. However, we think that any bounces in bond prices will likely be sold into as investors are left with a great deal of uncertainty on the future payment process and where CDS are likely to be a price point that widens as technical triggers are focused on.

Known Unknowns in Pari Passu ... and More to Come

posted by Anna Gelpern

The Friday decision in NML et al. v. Argentina has clearly shaken the sovereign universe. While I am normally more prone to panic than Felix Salmon or Vladimir Werning, these wise folks reasonably point out that the decision may spell the End of the World for sovereign immunity, sovereign debt as we know it, etc. "May" is the operative word in my view. We need more information and analysis (stay tuned) before we dash for the bunker.

Yes, it looks like previously unenforceable sovereign debt has suddenly become more enforceable. Zero to something. But how much? It depends on too many things to know for sure. Will the Second Circuit rehear the case en banc? Will the U.S. Government and those who sat on the sidelines in this round -- the IMF, the Federal Reserve, more intermediary banks -- pipe in? Will SCOTUS take the case? Will Judge Griesa pare back the effect of the injunction if Elliott wins the appeals? Vladimir is right that this will not go away. But we really do not know enough about what "this" is to say much more than that. We have a Second Circuit opinion that seems to disdain its own implications, and some history of SCOTUS slapping down Argentina when the U.S. Government was on the other side. Go figure. Ask your favorite court maven (I will).

Yes, Argentina's CDS have gone through the roof, correctly reflecting immense uncertainty about the near future of its foreign bond stock. But I doubt that either the courts or the policy establishment would find this fact compelling. Argentina has been a headache for too many for too long to elicit sympathy. What I really want to know -- consistent with the thrust of the U.S. brief -- is whether other sovereign and sovereign CDS spreads are going nuts, and if yes, which ones. The way Argentina wins here is by invoking the good of the system without overclaiming. No mean feat.

Yes, we seem to have a damagingly broad interpretation of pari passu out of the Second Circuit. Does it mean that a prospectus warning holdouts they might not get paid amounts to a subordination in violation of the pari passu clause, at least versions similar to Argentina's? Maybe. Will foreign courts adopt the Second Circuit's reading, exposing countries such as Italy to Argentina-scale uncertainty? Yikes. For what it's worth, this is where I feel most comfortable being worried. I will be looking for more data on just how many other countries have vulnerable formulations of the clause.

All this to say, there is a big difference between "mostly dead" and "all dead". And I suspect that Argentina -- and more so the broader universe of sovereign debt and sovereign immunity -- is "mostly dead" as far as pari passu goes. For now.

The pointy-head caucus can exhale -- the Second Circuit ruled on the pari passu drama, and it did not go as I had expected. Not only did the court rule against Argentina, but it did so on relatively broad grounds, giving a fair amount of meaning to a massively indeterminate bit of Latin, and ignoring the practical challenges of enforcing the ruling. The judges upheld the injunction directing Argentina to pay holdout creditors who refused to participate in its 2005 and 2010 debt exchanges whenever it services the new bonds that came out of the exchange. Ironically, the opinion acknowledged that it was impossible to figure out what proportionate payment would mean under the circumstances, but chucked the question back at the lower court. The judges also remanded the question of how exactly one might enforce this injunction without attaching sovereign property abroad or dragging in third parties (New York banks moving Argentina's money), despite the fact that the holdouts admitted in court that their next step would be to go after the banks on aiding and abetting theories. But these are all questions for another day. Between this ruling and the Ghana boat mess, October 2012 will go down as a heady month for Elliott and its kind.

Here are my main take-aways so far:

The court did not anchor its interpretation of the pari passu clause in Argentina's Lock Law, which bars the government from paying the holdouts, though the law got plenty of play. This was both risky and smart. It was risky because the court's reasoning might be construed to suggest that securities disclosure telling prospective holdouts that they would not be paid was tantamount to payment subordination. It was smart because a decision based solely on the Lock Law could be made moot by its repeal. I bet the "Risk Factors" sections of sovereign prospectuses are getting a close read just now.

The court adopted wholesale Elliott's reading of Argentina's two-part pari passuclause -- "[t]he Securities will constitute . . . direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu without any preference among themselves. The payment obligations of the Republic under the Securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness ..." (court's emphasis) -- effectively to punish Argentina for payment discrimination, whether or not it had subordinated the securities themselves. This is a big deal for two reasons.

First, violating the pari passu clause just got much easier, though I am not sure how far we can take the implications. Would missing a payment to one creditor while paying another amount to a distinct violation, and give the aggrieved creditor specific performance? This will depend on the precise wording of the clause, but the range of possibilities is considerably wider.

Second, contract drafters have a great new reason to let go the boilerplate schtick. Of course no one will start drafting each word from scratch. But this panel's textualist reading, interpretation technique straight out of Contracts textbooks, and its skepticism of Argentina's evidence on market custom, should jolt the contract production process. Not all bad.

The U.S. government got no love whatsoever. This could be because of the United States' awkward position of avoiding the Lock Law (still the right thing to have done, in my view), its pale oral argument, or because the opinion seemed determined to bracket its enforcement and policy implications. The goal was to bolster contracts and punish very bad debtors. So what if there is no way of enforcing the injunction without grabbing offshore property or New York banks--we are just telling Argentina what to do. So what if Greece has holdouts--its contracts are not under New York law. So what if the reading seems to cover international organizations -- creditors say they are not after them.

The opinion mentions Collective Action Clauses twice as both important, and a meaningful bar to future pari passu litigation. This is completely, totally, unambiguously wrong for all the reasons I have given before, and I cannot believe the judges did it when they did not have to. On the bright side, it gives me and my buddies more to write about.

This may not be as radical as it seems. Everyone would acknowledge that Argentina is an extreme case of vocal intransigence, even by defaulting sovereign standards. In another extreme case last summer, an English judge put an outer boundary on the use of exit consents in distressed debt exchanges. While initial reporting (mine included) suggested that this might seriously damage an established restructuring technique, later analysis suggested more of a modulation. I have said in the past that whatever pari passu means, Argentina is the closest I have seen to breach. Well, now a court says it too, if a bit more strongly than I would. Is it open season on sovereigns via pari passu, consequences be darned? I doubt it.

It is not over by a long shot. Apart from all the decisions that still have to be taken by the lower court on remand (which could end up gutting the injunction), Argentina will surely appeal. It will ask the full circuit to hear the case, and if it loses again, it will try to go to the Supreme Court. Much excitement to come, with lots of law to be made.

If I were Argentina, an agent bank, or much of the sovereign establishment, I would be shocked and dismayed. If I were Elliott, I would be dancing the jig. As it stands, I am looking forward to some really interesting law and policy developments to come.

Comments

But what does Elliott win?

If nobody can do anything to stop Argentina from transferring funds to intermediary banks and intermediary banks cannot be interfered with in making transfers to bondholders pursuant to Argentina's particular requests, how does Elliott end up with any money?

I know the intermediary bank issue is on remand, but it seems the Second Circuit is saying that the injunction cannot stop banks from paying exchange bondholders without paying defaulted bondholders.

The question in my mind is whether intermediary banks would touch anything Argentina with a ten-foot pole now, and if yes, what might it cost. Note also that because the math is totally up in the air, the injunction cannot be enforced until J. Griesa figures it out.

This is really fascinating, in large part because it's very much unexpected. Two questions come to mind:1) If by some act intermediary banks are in fact forced to follow the injunction, forcing Argentina to make a pro-rata payment to holdouts in order to continue servicing their performing debt, doesn't this mean that it constitutes an event of default on the currently performing debt? If memory serves me correctly, the exchange bond prospectus says that Argentina is not allowed to give holdouts a better offer than what it initially offered everybody. Does this matter at all to the courts?2. What would the timing look like for an injunction to be enforced, assuming that the Second District affirms whatever Griesa comes back with? This case has dragged on for a while but I wonder if we might see an unravelling within the next year or so.

Quite the unexpected decision. And, Anna, you're completely right that the court doesn't seem to grasp the relevance of CACs. On a couple of occasions, it says that CACs eliminate the possibility of holdout litigation, which of course is not the case. As you've pointed out before, most modern CACs are drafted in a way that allows holdout creditors to buy blocking positions in relatively small issues. No majority vote, no restructuring. From the opinion, it's obvious that the court doesn't grasp this.

On the other hand, I suspect the court went on its CAC bender in response to the US government's concern that injunctions like this might, in a future case, block a restructuring. And while CACs don't prevent holdouts - at least, not unless the bond provides for an aggregated vote across every bond issue - they probably do prevent holdouts from blocking a restructuring. (Not that holdouts block restructurings now, but, you know...) With CACs in place, won't holdouts be limited to buying reasonably small positions in reasonably small issues, so that the country can still get plenty of debt relief?

I cry not for Argentina, but maybe the intermediate banks do. The law says that they are fair game in asset forfeiture cases. But they are limited-- banks nowadays try to avoid criminals and banks that deal with criminals, and prosecutors are busy people.

Around 2002, the Second Circuit expanded this to admiralty. After years of howling by the banks, the court reversed itself. (The cases: Winter Storm and Jaldhi.) There has been another recent raft of cases along these lines inspired by the New York Court of Appeals in some truly knuckleheaded decisions: Hotel 71 and Koehler. (That's the highest state court.)

The problem, from the intermediate banks' perspective, is fairly simple. Garnishment is a middleman process. The garnishee gives to the court, and is compensated by the extinction of its creditor's asset. This works fine in one jurisdiction. But if you get multinational, there is no guarantee that a foreign court will recognize the extinction of its debt to its creditor (here, the respondent of the US correspondent bank). Indeed, it is often very likely that the foreign court would get rather huffy. It is being asked to choose between harming the respondent (who still owes its customer money) while violating norms of private international law, or complying with the norms and helping the locals. In law Latin, that's a no-brainer.

This is what happens when courts of appeal don't care if their decisions fit into reality (and when judges are briefed by recent law review editors with all the real world experience of Paris Hilton). This is a complete mess, and the CAC issue and the handling of holdouts is only the start. Following on Fernando's comments, if I were Argentina, I'd conclude that the US has already declared me in default in all respects and move my pieces around the board accordingly. Apparently the Second Circuit, for all its supposed cutting-edge decisions, still thinks money in the bank is physical money in a physical bank instead of electrons in a computer that can be moved to Dubai in the wink of an eye. And all future transactions just have to be in entities that can't be dragged into court in Manhattan (and yes, it can be done). The only thing Argentina really needs to avoid is jurisdictions like Ghana with judge-shaped objects that don't know the difference between waiver of sovereign immunity to suit and waiver of sovereign immunity to execution.

Elliott can dance all the jigs it wants, but it's likely to learn what I've been telling clients for over 25 years: Just because you have a judgment doesn't mean you can collect on it.